UK: Pensions Regulator Revises Clearance Guidance

In April 2005 the Pensions Act 2004 came into force. The Act gave the newly formed Pensions Regulator (the Regulator) so-called "Moral Hazard Powers" - powers to impose financial sanctions on employer companies and, potentially, connected or associated individuals, a defined benefit or hybrid occupational pension scheme in deficit: Contribution Notices and Financial Support Directions.

There was concern that the spectre of these sanctions could stifle corporate activity. To minimise this problem, parties were given the option of applying to the Regulator for clearance in respect of an event that could affect funding of the pension scheme. In return for the granting of clearance in respect of events considered to be materially detrimental to the scheme, there would generally have to be financial mitigation, for example, a lump sum payment, a schedule of additional contributions, a guarantee, a letter of credit or some other support.

At the same time as the Regulator came into being, so did the Pension Protection Fund (PPF). The Regulator was given the objective of protecting member benefits, in conjunction with the protection afforded by scheme trustees and the task of minimising the risk of claims on the PPF following the insolvency of an employer.

The clearance procedure was not prescribed by legislation and so the Regulator’s clearance guidance was written at a time when the clearance procedure was new and untested. With the benefit of two years’ practical experience under its belt the Regulator set about rewriting the clearance guidance. The 2007 draft revised guidance was issued for consultation on 10 September 2007.

The 2005 guidance referred to three types of events, Types A, B and C. A Type A event was an event that was materially detrimental to the funding of the scheme. This has been retained. Type B was an event that was not materially detrimental to the scheme. This definition has been of limited use and has essentially been used to confirm that an event is not Type A. The Type C label was designed for an event that was detrimental to the scheme but was not within the control of the employer, for example, the loss of a major customer. Type C has been rarely used in practice. Therefore references to Type B and C events have been removed from the latest guidance.

Materially detrimental events have now been divided into two categories, employer-related events and scheme-related events. Employer-related events would only be appropriate for clearance where there is a relevant deficit (see below). Scheme-related events are appropriate for clearance regardless of the level of the deficit unless there is absolutely no detriment to the scheme whatsoever. This will only be the case in limited circumstances.

A materially detrimental event is one that weakens the employer covenant. Such an event is also materially detrimental if it has the effect of preventing the recovery of an employer debt owed to the scheme, compromising or reducing the debt, these being events that could lead to a Contribution Notice being imposed. Trustees are warned to look out for a series of events that, together, would have one or more of these effects.

The revised guidance gives some examples of employer-related events but these are merely to assist and should not be taken to be a prescriptive definitive list. Examples given are events such as:

• changing the priority of any debt of the employer or in the wider group

• return of capital, particularly where money is being paid to group companies outside the EU or to parties which would not be subject to the Regulator’s moral hazard powers

• changes to the employer group structure

• "Phoenix" type situations and business sales whether from the employer or the wider group.

This is a longer list of events than in the 2005 guidance but does reflect the practice of the Regulator and is merely a reflection on the fact that the types of events that might appear in a clearance application were not anticipated to be as wide-ranging at the time the original 2005 guidance was written.

The relevant deficit to consider for clearance purposes is now the higher of FRS17, the PPF level of benefits, technical provisions (if the scheme has become subject to the new Scheme Specific Funding regime) and, if not, the scheme deficit calculated on an ongoing basis. It is not made clear whether the technical provisions should be calculated before or after the event, this figure being a moveable feast. If the relevant event causes there to be a deficit in technical provisions after the event, then this would suggest a material detriment to the scheme so that a calculation afterwards would appear to be appropriate.

However, before using any of these bases as the relevant deficit, the trustees should establish how detrimental to scheme funding the event in question might be. In the event of the sale of a company resulting in a high level of debt on the employer’s balance sheet or in the wider group, the Regulator has publicised that it would consider this to be an event causing significant detriment. This message was made clear, for example, when the Regulator was involved with the takeover of the Alliance Boots group of companies earlier this year.

A higher level of financial mitigation would be appropriate where there is significant detriment to the scheme or the ongoing viability of the employer in the long term is in doubt. Further, the buy-out deficit will be the appropriate yardstick where the event in question essentially amounts to scheme abandonment.

Examples of scheme-related events which will be appropriate for clearance, regardless of the level of deficit are debt compromises, apportionments, or arrangements that result in a section 75 debt not triggering or not being paid for a significant period of time.

While not expressly stated in the guidance, the mere introduction of an apportionment rule into the scheme drafted in a way that would not cause detriment should not suggest a need for clearance (for example, where the power can only be used with trustee consent as to how it is exercised, or where the timing and/or amount of the debt are subject to trustee consent). The use of such a rule will, however, be a Type A event. Exceptions to this, set out in the guidance, are where apportionment increases a debt immediately due from an employer which can afford to pay, where the best estimate of a debt is being paid (presumably immediately, although this is not expressly stated) in circumstances where the cost and complexity of approved withdrawal or other alternative arrangement are disproportionate and where there is no reduction in the employer covenant. For example, this might be the case where employers are consolidating.

Trustees should carry out an assessment of any scheme-related event and the appropriate mitigation (in terms of its materiality and potential effect on the employer covenant). This will generally be done in reliance upon a financial report prepared by an accountant specialising in pensions issues. Such reports would be expected to include recommendations as to the nature and amount of mitigation that the trustees should request of the employer and its group of companies.

Trustees are also reminded that they can revisit a recovery plan at any time, if considered appropriate having regard to the nature and effect on the scheme of the relevant event. However, arrangements made under the scheme specific funding regime are not an alternative to financial mitigation. Trustees may, for example, consider it appropriate to reopen the plan if the employer does not apply for clearance and does not pay an appropriate level of mitigation for the event to the scheme if this is likely to be a suitable alternative to mitigation.

Companies are reminded by the Regulator that clearance relates only to the event described in the clearance application. Clearance is not retrospective or forward-looking. This means, for example, that if, in the future, the scheme becomes insufficiently resourced then any party that is connected and associated could be a target for a Financial Support Direction (FSD) despite having been given clearance in respect of a previous event. The clearance given merely means that the event that was the subject of the application will not be taken into account when assessing whether it is reasonable to impose such a sanction. In practice the Regulator has been disinclined to give FSD clearance to parties who remain connected and associated after the event. If the Regulator can be persuaded to give clearance it is necessary for the applicant first to confirm that it understands the scope of the clearance requested. It may be easier to obtain FSD clearance now that the guidance itself sets out the scope of such clearance.

The 2007 guidance merely clarifies the Regulator’s current views and practice. There are no transitional issues. Therefore, although the guidance is still in a draft form it is appropriate to use it already. We believe that it is unlikely that there will be any substantial amendments to the guidance following consultation. However, at such time as the Occupational Pensions Schemes (Employer Debt) (Amendment) Regulations 2007 come into force (anticipated in December 2007) those prescribed changes will modify the current debt arrangements following the cessation of participation in a scheme. At that stage the clearance guidance will likely need to be amended to reflect those regulatory changes.

Clearance remains voluntary and while the guidance sets out the way in which the Regulator expects applicants and trustees to assess whether clearance could be applied for, it is not necessarily the case that, where an event appears to be a Type A event, clearance should be applied for. An applicant will need to consider whether the event could lead to the Regulator using its moral hazard powers. If this is improbable then the employer may consider that the cost of a clearance application (in terms of, for example, the cost of a covenant review) cannot be justified. On the other hand employers should have in mind that, if there is a transaction in the future that has an effect on the scheme, or if the position of the scheme deteriorates, the Regulator, when considering the reasonableness of using its powers, may take a past event into account.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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